Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 2 - Monetary Policy Framework : International Experience

The intellectual discourse in monetary policy has been strongly influenced by the classic Tinbergen (1952)-Theil (1961) policy framework in which each policy instrument is geared to meet a defined objective. Assuming there are no spillovers between different policies, monetary policy is best suited to achieve price stability. While price stability and output stabilisation are final objectives of monetary policy, they are not directly under the control of the central bank. Monetary authorities typically set intermediate targets in terms of macroeconomic variables, which bear a stable relationship with the overall objectives of monetary policy. This Section (articles 2 to 6 of the module) surveys the issues involved in each of the three elements of the monetary policy framework in terms of objectives, intermediate targets and instruments. The Section reviews briefly the debate regarding objectives of monetary policy. This is followed by a discussion on intermediate targets and even the very necessity of intermediate targets in the emerging inflation targeting framework. Finally, this Section evaluates the choices involved in adopting particular operating procedures of monetary policy.

Price stability - defined as low and stable inflation - is considered a key objective of monetary policy. It is now widely believed that monetary policy can contribute to sustainable economic growth through price stability. At the same time, the focus and the weight attached to the price stability objective evolved over time. During the 1960s and 1970s, the Phillips curve paradigm came to dominate monetary economics. It was believed that there exists not only a short-run but even a long-run trade-off between inflation and output. This led to a viewpoint that central banks could achieve higher growth on a sustainable basis, if they permit inflation to be a little higher. The pitfalls of this reasoning were brought out by the stagflation of the 1970s. These developments justified the stance taken by Phelps (1967) and Friedman (1968) who had argued that, once inflation expectations are taken into account, there existed no long-run trade off. The lessons learned from the spike in inflation in the 1970s brought about a renewed focus on price stability as a key objective of monetary policy. In the subsequent decades, inflation has been brought under control not only in advanced economies but also in developing and emerging market economies. In the latter group, the fall in inflation has been quite dramatic. Empirical evidence suggests that disinflations are associated with transitory output and employment losses. Typically, measured through sacrifice ratios, these losses are high even for independent central banks. Over longer periods of time, the decline in inflation need not be associated with any significant adverse impact on growth, consistent with a long-run vertical Phillips curve. In fact high inflation in the 1970s did not buy any additional growth either in developed countries or in EMEs. Issues related to the Phillips curve, the build-up of inflation, the subsequent moderation and the reasons for this rise and fall are explored further in Module 3.

Although low and stable inflation is the final objective, it is not inconsistent with stabilisation of output - around its potential - by monetary authorities. In fact, monetary policy affects inflation not directly but via its impact on aggregate demand in the economy. Thus, even if price stability is the objective of monetary policy, monetary authorities have a key role to play in the stabilisation of output and employment in the economy. This is reflected in the charters of central banks. Amongst advanced economies, some central banks such as the US Federal Reserve have multiple objectives of price stability, maximum employment and moderate long-term interest rates but many like the United Kingdom and the European Central Bank have hierarchical objectives. In the latter case, price stability is the primary objective, and subject to that, these central banks are concerned about growth and employment. However, the distinction between the two categories is now much less pronounced. Both groups of central banks are as much concerned about price stability as they are about deviations of output from its potential. In the words of Mervyn King, neither group is a "inflation nutter" and they are better described as flexible inflation targeters. While many central banks may in practice continue to attempt to stabilise output, they find it useful for their public mandate to be restricted to price stability alone, since this reduces their vulnerability to political pressure for expansionary policy.

While price stability remains a key objective of monetary policy, central banks in EMEs have generally tended to follow multiple objectives, especially as they are usually assigned a key role in promoting economic development. Besides, in EMEs that are relatively more open, exchange rates often emerge as a key policy issue. Empirical evidence suggests that in EMEs central bank interest rates often react more strongly to the changes in the exchange rate rather than changes in the inflation rate or the output gap. At the same time, a number of EMEs are gradually veering to a sole price stability objective.(Table 1)

This switch to single/ hierarchical mandates has occurred as these economies have adopted inflation targeting frameworks during the 1990s. The usefulness of inflation targeting frameworks in both advanced and emerging economies continues to be a matter of debate. While it is true that many inflation targeting economies reduced inflation during the 1990s, so has been the case with countries that have not adopted inflation targeting.

Paradoxically, the 1990s - a decade of price stability - witnessed a number of episodes of financial instability suggesting that price stability by itself is not sufficient. As stated earlier, globalisation and integration of economies with the rest of the world have thrown up new challenges for monetary policy. Large movements in capital flows and exchange rates affect the conduct of monetary policy on a daily basis. These impact not only demand and inflation but also balance sheets of residents. Large and sudden changes in exchange rates have, therefore, implications for financial stability. Beyond the traditional trade-off between inflation and growth, there is now thus the challenge of financial stability. This has led to an intense debate as to how monetary policy can contribute to financial stability. While it is true that price stability is necessary for financial stability, it is increasingly clear that price stability, per se, is not sufficient to guarantee financial stability. One line of argument suggests that central banks should continue to focus on achieving the macroeconomic goal of low and stable inflation as it is difficult to identify potential sources of financial instability. In this view, asset price misalignments are not easy to identify ex ante. And, even if it was possible to do so, it is debatable as to whether monetary policy can prick these bubbles. An alternative view is that central banks should pro-actively tighten monetary policy and monitor various indicators such as credit and monetary aggregates to identify incipient financial imbalances. Accordingly, central banks need to extend their policy horizon beyond the usual two-year period as financial imbalances need not necessarily show up in overt inflation in such a short period. Furthermore, given the limitations of monetary policy, effective regulation and supervision of financial institutions have assumed importance (see Module: 6 for a further discussion).

To sum up, the debate over the objectives that monetary policy can pursue is far from settled. While price stability remains the key objective of monetary policy, global integration is increasingly requiring central banks to focus on financial stability as well. Although the possible multiple goals of price stability, economic growth and financial stability are mutually reinforcing in the long run, the critical issue in the design of monetary policy is to meet the challenges of the trade-offs in the short run, which involve conscious policy choices. While there is very little disagreement over the fact that price stability should remain a key objective of monetary policy, reservations persist about adopting it as the sole objective of monetary policy.